What U.S. Dollar’s Recent Strength Means For Prospects

OCEAN CITY — One of our investment themes for this year has been the likelihood of an improving U.S. economy, accompanied by a stronger U.S. dollar. Second-quarter growth of U.S. gross domestic product (GDP) was just revised upward to 4.6% on an annualized basis, the largest quarterly gain since 2011.

Meanwhile, the U.S. dollar rallied more than 7% in the third quarter. This week, we examine the recent strength of the dollar, its impact on certain assets and expectations going forward.

The strength of the dollar can be attributed largely to better prospects for growth and inflation in the U.S. compared to other regions, coupled with a divergence in monetary policy from those of Europe and Japan. The

Federal Reserve (Fed) is expected to conclude its quantitative easing program this month. Our base case is that the Fed’s tightening cycle will be gradual and well-communicated, and that even after the first rate hike the central bank will have a reasonably long runway in normalizing rates. Meanwhile, growth in many other areas is wavering, and central banks are stepping in to boost their economies.

In September, in an effort to fight deflationary pressures, the European Central Bank (ECB) cut interest rates and its President Mario Draghi previewed a plan to purchase asset-backed securities and covered bonds issued by financial institutions. This is a reversal from recent years, which have seen the ECB shrink its balance sheet as the Fed did the reverse. These developments have caused the euro to depreciate by more than 7% against the dollar since the end of June.

The U.S. dollar’s move relative to the Japanese yen has also been significant, with the yen reaching the lowest level since 2008 amid a backdrop of accommodative monetary

policy. Beyond developed markets, a slowdown in China came as a surprise to the markets over the summer, as growth in industrial production slowed to an annual rate of 6.9% in August from 9.0% in July. These divergences in monetary policy and economic growth across global economies could continue to provide support for the U.S. dollar.

Traditionally a stronger dollar is bearish for commodities, and they have been a big casualty of the dollar’s recent surge, declining by about 12%2 since the end of June. Weaker growth prospects outside the U.S. have been a factor as well. With the Fed en route to tightening monetary policy and the resulting dollar strength it will be difficult for commodities to rally without a meaningful uptick in global growth, in our view.

The decline in commodity prices alongside the appreciating dollar has put the brakes on a rally in Emerging Market equities since spring. This outcome is unsurprising given the reliance of many developing economies on strong commodity fundamentals. We continue to favor a selective approach to Emerging Markets in the medium term, favoring areas that benefit from government reforms.

We are mindful that both the decline of commodities and the dollar’s rally may be getting stretched in the near-term. However, the moves are likely structural in nature. Sustained commodity rallies look unlikely due to slower economic growth outside the U.S. and expanding output, especially in the energy sector. Similarly, the U.S. dollar could remain firm due to the outperformance of the U.S. economy, along with the country’s improving fiscal health and transformative changes like the surge in domestic energy production.

Ultimately, a stronger dollar signals growing global confidence in U.S. assets and foreign capital inflows, contributing to further growth.

(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)